Mathematics of Options Futures and Derivative Securities II

MA5076
Mathematics of Options, Futures,

and Derivative Securities II.
Daniel Spirn,
School of Mathematics,
University of Minnesota.
Options, Futures, Derivatives / January 28, 2008
Syllabus
Semester I
Semester II
1. Review of Black-Scholes
1. Mechanics of Futures Markets
2. Review of Greeks
2. Hedging Strategies Using Futures
3. Volatility Smiles
3. Interest Rate Markets
4. Basic Numerical Procedures
4. Determination of of Forward and Future Prices
5. Value at Risk
6. Time Series
5. Interest Rate Futures
7. Estimation of Volatilities and Correlations
6. Swaps
8. Credit Risk
7. Mechanics of Options Markets
9. Credit Derivatives
8. Properties of Stock Option Prices

9. Trading Strategies Involving Options
10. Exotic Options

11. Weather, energy, and insurance derivatives
12. More on models and numerical procedures
10. Binomial Trees
13. Martingales and measures
11. Wiener Processes and Itos Lemma
14. Interest Rate Derivatives
12. The Black-Scholes Model
15. Convexity, timing, and quanto adjustments
13. Options on Stock Indices, Currencies and Futures
16. Models of Short Rate

17. Heath-Jarrow-Morton
14. The Greek Letters
18. Swaps revisited
15. Volatility Smiles
19. Real Options
Class Information
Lecture: Mondays & Wednesdays 5:00PM6:30PM.
Lecture Room: Vincent Hall 20
Office Hours: Mondays 3:00PM4:30PM
Office: Vincent Hall 112b
Contact: spirn@math.umn.edu & 612-625-1349
Textbook: Options, Futures, and Other Derivatives, 6th Edition, John Hull,
Prentice Hall.
Grade Information:
Homework:
Midterm:
Final:
50 %
20 %
30 %
What is a derivative?
What is a derivative?
A financial instrument whose value derives from the value of underlying variables.
or
Financial instruments whose price and value derive from the value of assets underlying them. 1
or
Financial contracts whose value derive from the value of underlying stocks, bonds, currencies,
commodities, etc.
Examples:
Future contract for orange juice. Not the orange juice itself.
Option to buy/sell a stock. Not the stock itself.
Edmund Parker
Asset Derivatives
Examples
Commodity Derivatives - Pork Bellies (Trading Places), Precious Metals
Equity Derivatives - Stocks / Bonds
Interest Rate Derivatives - Interest Rates
Currency Derivatives - Currency Exchange Rates (Yen vs. Euro)
Property Derivatives - Real Estate
Other More Exotic Derivatives
Why trade derivatives?
Used to protect assets from drastic fluctuations

Covers many kinds of risk.
Allows access to financial instruments with considerably larger risk than
conventional assets (speculation).
Financial instruments used in derivative transactions
Forwards
Futures
Options
Swaps
Forward Contracts
Definition: A forward contract is an agreement to buy or sell an asset

at a certain time for a certain price. Usually traded in the OTC market.
One party assumes a long position by agreeing to buy the underlying asset
on a specified future date for a specified price.
The other party assumes a short position by agreeing to sell the underlying asset
on the same date and at the same price.
Definition: A spot contract is an agreement to buy or sell an asset today.

Spot contracts are for immediate delivery of the asset.
Common among currency derivatives.
Futures Contracts
Similar to a forward contract - it is an agreement between two parties to buy or

sell an asset at a certain time in the future for a certain price.
However, futures are usually traded in exchanges.
Mechanisms by the exchange to guarantee that the contract will be honored.
Example: Chicago Mercantile Exchange (CME) trades futures on
commodities such as pork bellies, orange juice, copper, sugar, etc.
financial assets such as stock indices, currencies, Treasury bonds, etc.
Mechanisms for such exchanges will be explained next week.
Options Contracts
The third type of derivative we will discuss is an options contract. These are
divided into two types:
A call option entitles the holder the right to buy the underlying asset by a
certain date for a certain price.
A put option entitles the holder the right to sell the underlying asset by a
certain date for a certain price.
Some more terminology:
The price in the contract is the strike price or the exercise price.
The date in the contract is known as the expiration date or maturity.
10
Types of options
American options can be exercised at any time up to the expiration date.

European options can be exercised only on the expiration date.
Mathematics involved in American options is more difficult than European options.
One contract is usually an agreement to buy or sell 100 shares.
Note an option is exactly that - an option to exercise the right to buy or sell.
The holder of the option does not need to exercise the option.
11
Participants in Options Markets
Four types of participants in the Options markets, as yet:

Buyers of calls
a long position
Sellers of calls
a short position
Buyers of puts
a long position
Sellers of puts
a short position
Selling an option is also known as writing the option.
12
Types of derivative traders in the market
Hedgers - use derivatives to reduce risk in the market from potential future
market movements.
Speculators - trade derivatives to bet on the future direction of a market
variable.
Arbitrageurs - take offsetting positions in two or more instruments to lock in a
profit. (usually short-lived)
13
Arbitrageurs
Third important group of traders in derivatives. Involves locking in riskless profit

by simultaneously entering into transactions in two or more markets.
Mostly possible when future prices become out of line with spot prices.
Transaction costs may gobble up most of the profit for small investments, but
large financial institutions could profit. Furthermore, arbitrage opportunities are
quickly lost.
Useful for determining the monetary value of certain derivatives.
14
Wiener Processes and It

os Lemma
More sophisticated approach to modeling the behavior of assets underlying derivatives - view
motion as a stochastic process.
A stochastic process is a process where future evolution is described by probability distributions.
Two types: discrete-time stochastic process changes values at discrete time steps. A
continuous-time stochastic process changes value at any time.
Stochastic process can be continuous variable or discrete variable. A continuous-variable process
can take any value within a certain range. (motion of a particle in fluid). A discrete-variable
process can take only certain prescribed values. (coin flips)
Markov Process is a stochastic process where only present value of a variable is relevant for
predicting the future. Coin flips are Markovian. If we flip the coin 30 times and comes up heads 30
straight times, next flip still 50/50 chance.
15
Normal Distribution
Let (, )(x) denote the normal distribution. Then satisfies

(x)
1
(, )(x) = e 22
2
Probability of sum of
16
Normal Distribution
N (, ) =
(, )(s)ds
N (, )(+) = 1
Consider a random number x (0, 1) then most likely within the middle of the curve, if we undo
it.
Sums of two normal distributions mean zero is a normal distribution with mean zero and variance
thats the sum of the two variances. Proof: next time.
17
Continuous-Time Stochastic Processes
Consider a Markov stochastic process. Suppose that the current value is 10 and the change in
its value during 1 year is (0, 1).
After two years? The change in two years is a some of two one year Markov stochastic process
with mean zero and standard deviation 1.
Therefore, the sum is
a normal distribution with mean zero and variance 1 + 1 = 2. Thus the
standard deviation is 2.
Consider now the change in the variable during 6 months. The variance of the change in the
value of the variable during 1 year equals the variance of the change during the first 6 months
plus the variance of the change during the second 6 months.
We assume they are the same. Then variance
of change during a 6-month period must be
0.5.
Thus, the standard deviation of the change is 0.5. Thus 6-month distribution is (0, 0.5).
Consider a small time step t = N1 , during which each period is an independent normal
distribution. Then sum of the variances are equal to 1, so each variance should be t.
The standard deviation then is t.
Uncertainty is proportional to square root of time.
18
Wiener Processes
We continue letting t 0 carefully! This is called the Wiener process or Brownian motion. It is
a Markov stochastic process with mean zero and variance 1.0 per year. Therefore, it has
1. Change z during a small period of time t is
z = t
where has a standardized normal distribution (0, 1). Therefore, z has a normal
distribution with
mean of z = 0
standard deviation of z = t
variance of z = t.
2. Values of z for any two different short intervals of time t are independent. Therefore, z
follows a Markov process.
19
Wiener Process cont.
Measure the value of z(T ) z(0) over a long period of time T .

View as a sum of N small changes over small time changes t, i.e.
N
X
T
i t
N =
= z(T ) z(0) =
t
i=1
where i for i {1, . . . , N } are distributed (0, 1). The is are independent of each other.
Then z(T ) z(0) is normally distributed with
mean of [z(T ) z(0)] = 0

variance of [z(T ) z(0)] = N t = T
standard deviation of [z(T ) z(0)] = T .
20
Approximating Wiener Process
21
22
1. Expected length of the path followed by z in any time interval is infinite!

2. Expected number of times z equals any particular value in any time interval is
infinite!
23
Wiener Process
Self-similar structure. Lies in C 0, 2 .

24
Generalized Wiener Process
The mean change per unit time for a stochastic process is known as the drift rate.
The variance per unit time for a stochastic process is known as the variance rate.
A generalized Wiener process for a variable x can be defined in terms of dz as
dx = adt + bdz
where adt is the expected drift rate of a per unit time.
Holds since dx = adt =
dx
dt
= a. Therefore,
x = x0 + at
After time T the variable x travels T units.
25
The term b dz regarded as noise added to the system, which is b times a Wiener process.
In a small time interval t, the change x in the variable of x is given by
x = at + b t
where has a standard normal distribution.
mean of x = at
standard deviation of x = b t
variance of x = b2t.
The same argument show that the change in the value of x in any time interval T is normally
distributed with
mean of x = aT
standard deviation of x = b T
variance of x = b2T .
26
27
It
o Process
A generalized Wiener process in which the parameters a and b are functions of the value of the
underlying variable x and t. An It
o process can be written as
dx = a(x, t)dt + b(x, t)dz

Both the expected drift rate and the variance rate of an It
o process are liable to change over time.
In a small time interval between t and t + t, the variable changes from x to x + x, where
x = a(x, t)t + b(x, t) t

Thus b2 is the variance and a is the mean during the interval between t and t + t.
28
Process for a stock price

Discuss the process that models stock movements for a nondividend paying stock:
Expected drift
is constant
Stock price
If S is the stock price a time t, then the expected drift rate in S should be assumed to be S
for some constant parameter .
So in short period of time t the expected increase in S should be St.
Expected return =
If volatility of the stock is zero then model implies
S = St
In the limit t 0,
dS = Sdt
or
dS
= dt
S
Then
ST = S0 e
29
Process for a stock price
Including volatility then expect: variability of the percentage return in a short period of time t is
the same regardless of the stock price. This suggests that the standard deviation of the change in
a short period of time t should be proportional to the stock price and leads to
dS = Sdt + Sdz
or
dS
= dt + dz
S
(1)
We use (1) to price stocks. Here is the volatility and is the expected return rate.
Limiting case of the random walk we saw with binomial trees.
30
Discrete-Time Model
Discrete-time version of the model is
S
= t + t
S
(2)
so the change in the stock value over a short period of time is
S = St + S t
Variable S is the change in the stock price S over a small interval of time t and has a
standard normal distribution (normal distribution with = 1 and = 0).
is the expected rate of return by the stock in a short period of time t.
is the volatility of the stock price.
31
Discrete-Time Model
Left-hand-side of (2) is the return provided by the stock in a short period of time.
Term t is the expected value of the return
Term t is the stochastic component of the return. Variance is 2t (consistent with

the definition of volatility defined earlier).
Then S/S is normally distributed with mean t and standard deviation t, so
S
(t, t)
S
32
Parameters
The development of the pricing model depends on and so far.

For derivatives that depend on the stock, not important to have . However, very important to
have . We saw this with binomial tree pricing.
The standard
deviation of the proportional change in the stock price in a small interval of time t
is t. The standard deviation of the proportional change

in the stock price over a relatively
long period of time T is T .
33
It
os Lemma
An It
o process is one in which the drift and the volatility depend on both x and t. Suppose x is an
It
os process then

where dz is a Wiener process and a, b are functions of x and t. Then x has a variance b2.
It
os Lemma states that a function G of x and t follows the following process:
!
2
G
G
G
1 G 2
dt
+
dG =
a+
+
b
bdz
x
t
2 x2
x
In particular G is an It
o process with drift rate
G
G
1 2G 2
a+
+
b
2
x
t
2 x
and variance
G 2 2
b
x
34
It
os Lemma - formal argument
Assume G is a function of two variables x and t then we can formally take a power series expansion
G
1 2G
2G
1 2G
G
2
2
3
x +
t +
(x)
+
(xt)
+
(t)
+
O(
)
G =
x
t
2 x2
xt
2 t2
An It
o process satisfies

where dz is a Wiener process. Then approximately (at the discrete level) we have
x = a(x, t)t + b(x, t) t.

Then returning to G we have
G
G
1 2G
2G
1 2G
2
2
3
G =
x +
t +
(x)
+
(xt)
+
(t)
+
O(
)
2
2
x
t
2 x
xt
2 t
i G
G h
=
at + b t +
t
x
t
h
i2
i 1 2G
1 2G h
2G
2
3
+
at
+
b
t
+
t
at
+
b
t
+
(t)
+
O(
)
2
2
2 x
xt
2 t
Expand out:
35
It
i G
G h
G =
at + b t +
t
x
t
h
i2
i 1 2G
2G
1 2G h
2
3
t
+
t
+
+
at
+
b
t
at
+
b
(t)
+
O(
)
2 x2
xt
2 t2
G
= tb
x
"
#
2
G
G
2 21 G
+ t
a+
+b
x
t
2 x2
"
#
2
3
1 G
+ (t) 2 2ab
2 x2
"
#
2
2
2
G
1 G
2
21 G
3
+ (t) a
+
a
+
+
O((t)
)
2 x2
xt
2 t2
"
#
2
3
G
G
G
2 21 G
a+
+b
t +
b t + O((t) 2 )
=
2
x
t
2 x
x
36
It
Therefore,
"
#
2
3
G
G
G
2 21 G
G =
a+
+b
b t + O((t) 2 )
t +
2
x
t
2 x
x
Since is a normal distribution, then the variance 2 is 1. Thus 1 = E(2) (E())2 = E(2).
Therefore, the expected value of 2t is t (small fluctuations cancel out) and hence
nonstochastic! Take the limit as t 0 then get formally
"
#
2
G
G
G
21 G
dG =
a+
+b
dt
+
bdz
x
t
2 x2
x
37
It
os Lemma: Modeling stock movements
We argued that a reasonable model of stock movements should be
dS = Sdt + Sdz
with and constants.
From Itos Lemma we can consider a process G that depends on t and S . Then
!
2
G
G
1 G 2 2
G
dG =
S +
+
S
dt
+
Sdz
S
t
2 S 2
S
so both S and G are affected by dz - the noise in the system.
38
Lognormal Property
Recall that our model requires
dS = Sdt + Sdz
with and constants.
Define G = ln S then
1
G
=
S
S
2G
1
=
S 2
S2
G
=0
t
by It
os Lemma we have
!
2
G
G
1 G 2 2
G
dG =
S +
+
S
Sdz
dt
+
S
t
2 S 2
S
1
1 1 2 2
1
=
S + 0 +
S dt + Sdz
S
2 S2
S
!
2
dt + dz
=
2
39
Therefore, G follows a generalized Wiener process with

2
Drift = 2
Variance = 2
40
Lognormal Property
Therefore, the change in ln S between 0 and a future time T is normally distributed with mean
2
( 2 )T and variance 2T . Hence:
"
ln ST ln S0
T, T
or
"
ln ST ln S0 +
T, T
This implies that log of the stock price is normally distributed:

A variable has a lognormal distribution if the natural log of the variable is normally distributed.
The standard deviation of the logarithm of the stock price is T .
41
Derivation of Black-Scholes-Merton Differential Equation
We are now in position to derive the Black-Scholes or Black-Scholes-Merton differential equation.

We build the model via a riskless portfolio, as we did for binomial trees. As for binomial trees, we
carry some stock along with shorting the option. The amount of stock changes instantaneously.
Special assumptions are required:
1. The stock price follows the process defined earlier for and :
dS
= dt + dz
S
2. Short selling of securities with full use of proceeds is permitted
3. There are no transactions costs or taxes. All securities are perfectly divisible
4. There are no dividends during the life of the derivative
5. There are no riskless arbitrage opportunities
6. Security trading is continuous
7. The risk-free rate of interest, r , is constant and the same for all maturities
42
Recall our process for a continuous stock movement modeled on an Ito process with expected gain
and volatility .
dS = Sdt + Sdz
Let f be the price of a call option that depends on S . The variable f depends, then S and t. Then
!
2
f
f
1 f 2 2
f
df =
S +
+
Sdz
S
dt
+
2
S
t
2 S
S
Recall the discrete-time analogues as
S = St + S t
and so the discrete version of It
os Lemma is:
!
2
f
f
1 f 2 2
f
S +
+
S
S t
f =
t +
S
t
2 S 2
S
43
We now build a portfolio that will eliminate the stochasticity of the process. The appropriate
portfolio (as we will see) is
-1 option
f
S
shares ( =
fu fd
S0 uS0 d
is the Delta hedge found in binomial trees)
which changes continuously over time. Let be the value of the portfolio then
= f +
f
S
and be the value of the portfolio in the time interval t then
= f +
f
S
S
44
Then
f
= f +
S
S
!
"
#
2
f
f
1 f 2 2
f
S +
+
Sz
S
t
+
=
2
S
t
2 S
S
f
+
[St + Sz]
S
"
#
2
1 2 2 f
f
+ S
=
t
t
2
S 2
Note that does not depend on dz , therefore there is no risk during time t! Thus the
portfolio must instantaneously earn the same rate of return as other short-term risk-free securities.
If it earned more than this return, arbitrageurs could make a riskless profit by borrowing money to
buy the portfolio; if it earned less they could make a riskless profit by shorting the portfolio and
buying risk-free securities. Thus:
= rt
45
where r is the risk-free rate. Then
"
f
1 2 2 f
f
+ S
t = f +
S t
t
2
S 2
S
so
f
f
1 2 2 2f
+ rS
+ S
= rf
pt
S
2
S 2
(3)
Equation (3) is the Black-Scholes partial differential equation. Any solution corresponds to the
price of a derivative overlying a particular stock.
In order to specify further what the derivative is, we use a boundary condition to constrain it.
46
Boundary conditions for European call options:
f = max{S K, 0}
when t = T . Boundary conditions for European put options:
f = max{K S, 0}
when t = T . The portfolio created is riskless only for infinitesimally short periods.
47
Tradeable Derivatives
Any function f (S, t) that satisfies (3) is the theoretical price of a derivative that could be traded.
If a derivative with that price existed, then there would be no arbitrage opportunities
Conversely if a function f (S, t) does not satisfy (3) then it cannot be the price of a derivative
without creating arbitrage opportunities.
Example: Let f (S, t) = eS then ft = 0, fS = eS , and fSS = eS then
ft + rSfS + 12 2fSS = rSeS + 21 2eS 6= reS . Thus this cannot be a derivative of a stock price.
On the other hand
f =
2 2r (T t)
then
2
ft = 2r f
fS =
fSS = 2
2 2r (T t)
S2
2 2r (T t)
S3
= rSfS = rf
2 2
2
=
S fSS = f
2
48
Tradeable Derivatives
so
2 2
2
2
ft + rSfS +
S fSS = f + 2rf rf + f = rf
2
which is the Black-Scholes differential equation. This the price of a derivative that pays off
time T .
1
ST
at
49
Black-Scholes Pricing Formulas
The Black-Scholes formulas for the price at time 0 of a European call option on a
non-dividend-paying stock and for a European put option on a non-dividend paying stock are
rT
N (d2)
rT
N (d1)
c = S0N (d1) Ke
and
p = KN (d2) S0e
ln
S0
K
ln
S0
K
d1 =
d2 =
where
2
+ r+ 2 T
2
+ r 2 T
= d1 T
and N (x) is the cumulative probability distribution function.

50
Black-Scholes Pricing Formulas
The variables c and p are the European call and put prices, S0 is the current stock price at time 0,
K is the strike price, r is the continuously compounded risk-free rate, is the stock price
volatility, and T is the time to maturity of the option. Why?
51

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MA5076

Mathematics of Options, Futures,

Options, Futures, Derivatives / January 28, 2008

1. Mechanics of Futures Markets

2. Hedging Strategies Using Futures

3. Interest Rate Markets

4. Basic Numerical Procedures

4. Determination of of Forward and Future Prices

5. Interest Rate Futures

7. Estimation of Volatilities and Correlations

7. Mechanics of Options Markets

8. Properties of Stock Option Prices

10. Exotic Options

10. Binomial Trees

13. Martingales and measures

11. Wiener Processes and Itos Lemma

14. Interest Rate Derivatives

12. The Black-Scholes Model

15. Convexity, timing, and quanto adjustments

13. Options on Stock Indices, Currencies and Futures

16. Models of Short Rate

14. The Greek Letters

18. Swaps revisited

15. Volatility Smiles

19. Real Options

Options, Futures, Derivatives / January 28, 2008

Options, Futures, Derivatives / January 28, 2008

Options, Futures, Derivatives / January 28, 2008

Options, Futures, Derivatives / January 28, 2008

Why trade derivatives?

Used to protect assets from drastic fluctuations

Options, Futures, Derivatives / January 28, 2008

Financial instruments used in derivative transactions

Options, Futures, Derivatives / January 28, 2008

Definition: A forward contract is an agreement to buy or sell an asset

Definition: A spot contract is an agreement to buy or sell an asset today.

Options, Futures, Derivatives / January 28, 2008

Similar to a forward contract - it is an agreement between two parties to buy or

Options, Futures, Derivatives / January 28, 2008

Options, Futures, Derivatives / January 28, 2008

American options can be exercised at any time up to the expiration date.

One contract is usually an agreement to buy or sell 100 shares.

Options, Futures, Derivatives / January 28, 2008

Participants in Options Markets

Four types of participants in the Options markets, as yet:

Selling an option is also known as writing the option.

Options, Futures, Derivatives / January 28, 2008

Types of derivative traders in the market

Options, Futures, Derivatives / January 28, 2008

Third important group of traders in derivatives. Involves locking in riskless profit

Options, Futures, Derivatives / January 28, 2008

Wiener Processes and It

Options, Futures, Derivatives / January 28, 2008

Let (, )(x) denote the normal distribution. Then satisfies

Options, Futures, Derivatives / January 28, 2008

Continuous-Time Stochastic Processes

The standard deviation then is t.

Uncertainty is proportional to square root of time.

Options, Futures, Derivatives / January 28, 2008

Options, Futures, Derivatives / January 28, 2008

Wiener Process cont.

Measure the value of z(T ) z(0) over a long period of time T .

mean of [z(T ) z(0)] = 0

standard deviation of [z(T ) z(0)] = T .

x = a(x, t)t + b(x, t) t

Term t is the stochastic component of the return. Variance is 2t (consistent with

x = a(x, t)t + b(x, t) t.